Microeconomics theory through applications

Preface
We have written a fundamentally different text for principles of economics, based on two premises:
1.

Students are motivated to study economics if they see that it relates to their own lives.

2. Students learn best from an inductive approach, in which they are first confronted with a question
and then led through the process of how to answer that question.

The intended audience of the textbook is first-year undergraduates taking courses on the principles
of macroeconomics and microeconomics. Many may never take another economics course. We aim
to increase their economic literacy both by developing their aptitude for economic thinking and by
presenting key insights about economics that every educated individual should know.

Applications ahead of Theory
We present all the theory that is standard in books on the principles of economics. But by
beginning with applications, we also show students why this theory is needed.
We take the kind of material that other authors put in “applications boxes” and place it at the heart of our
book. Each chapter is built around a particular business or policy application, such as (for
microeconomics) minimum wages, stock exchanges, and auctions, and (for macroeconomics), social
security, globalization, and the wealth and poverty of nations.
Why take this approach? Traditional courses focus too much on abstract theory relative to the interests
and capabilities of the average undergraduate. Students are rarely engaged, and the formal theory is never
integrated into the way students think about economic issues. We provide students with a vehicle to
understand the structure of economics, and we train them how to use this structure.

A New Organization
Traditional books are organized around theoretical constructs that mean nothing to
students. Our book is organized around the use of economics.

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Our applications-first approach leads to a fundamental reorganization of the textbook. Students will not
see chapters with titles like “Cost Functions” or “Short-Run Fluctuations.” We introduce tools and ideas
as, and when, they are needed. Each chapter is designed with two goals. First, the application upon which
the chapter is built provides a “hook” that gets students’ attention. Second, the application is a suitable
vehicle for teaching the principles of economics.

Learning through Repetition
Important tools appear over and over again, allowing students to learn from repetition and
to see how one framework can be useful in many different contexts.
Each piece of economic theory is first introduced and explained in the context of a specific application.
Most are reused in other chapters, so students see them in action on multiple occasions. As students
progress through the book, they accumulate a set of techniques and ideas. These are collected separately
in a “toolkit” that provides students with an easy reference and also gives them a condensed summary of
economic principles for exam preparation.

A Truly International Book
International economics is not an afterthought in our book; it is integrated throughout.
Many other texts pay lip service to international content. We have taught in numerous countries in
Europe, North America, and Asia, and we use that expertise to write a book that deals with economics in a
globalized world.

Rigor without Fear
We hold ourselves to high standards of rigor yet use mathematical argument only when it
is truly necessary.
We believe students are capable of grasping rigorous argument, and indeed are often confused by loose
argumentation. But rigor need not mean high mathematical difficulty. Many students—even very bright

ones—switch off when they see a lot of mathematics. Our book is more rigorous yet less overtly

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mathematical than most others in the market. We also include a math/stat toolkit to help students
understand the key mathematical tools they do need.

A Textbook for the 21st Century
We introduce students to accessible versions of dynamic decision-making, choice under
uncertainty, and market power from the beginning.
Students are aware that they live in an uncertain world, and their choices are made in a forward-looking
manner. Yet traditional texts emphasize static choices in a world of certainty. Students are also aware that
firms typically set prices and that most firms sell products that are differentiated from those of their
competitors. Traditional texts base most of their analysis on competitive markets. Students end up
thinking that economic theory is unrealistic and unrelated to the real world.
We do not shy away from dynamics and uncertainty, but instead introduce students to the tools of
discounted present value and decision-making under uncertainty. We also place relatively more emphasis
on imperfect competition and price-setting behavior, and then explain why the competitive model is
relevant even when markets are not truly competitive. We give more prominence than other texts to topics
such as basic game theory, statistics, auctions, and asset prices. Far from being too difficult for principles
students, such ideas are in fact more intuitive, relevant, and easier to understand than many traditional
topics.
At the same time, we downplay some material that is traditionally included in principles textbooks but
that can seem confusing or irrelevant to students. We discuss imperfect competition in terms of market
power and strategic behavior, and say little about the confusing taxonomy of market structure. We
present a simplified treatment of costs that—instead of giving excruciating detail about different cost
definitions—explains which costs matter for which decisions, and why.

A Non-Ideological Book
We emphasize the economics that most economists agree upon, minimizing debates and
schools of thought.

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There is probably less ideological debate today among economists than there has been for almost four
decades. Textbooks have not caught up. We do not avoid all controversy, but we avoid taking sides. We
choose and present our material so that instructors will have all the tools and resources they need to
discuss controversial issues in the manner they choose. Where appropriate, we explain why economists
sometimes disagree on questions of policy.
Most key economic ideas—both microeconomic and macroeconomic—can be understood using basic tools
of markets, accounting identities, and budget sets. These are simpler for students to understand, are less
controversial within the profession, and do not require allegiance to a particular school of thought.

A Single Voice
The book is a truly collaborative venture.
Very often, coauthored textbooks have one author for microeconomics and another for macroeconomics.
Both of us have researched and taught both microeconomic and macroeconomic topics, and we have
worked together on all aspects of the book. This means that students who study both microeconomics and
macroeconomics from our book will benefit from a completely integrated and consistent approach to
economics.

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Chapter 1

What Is Economics?
Fast-Food Economics
You are just beginning your study of economics, but let us fast-forward to the end of your first economics
course. How will your study of economics affect the way you see the world?
The final exam is over. You are sitting at a restaurant table, waiting for your friends to arrive. The place is
busy and loud as usual. Looking around, you see small groups of people sitting and talking animatedly.
Most of the customers are young; this is not somewhere your parents visit very often. At the counter,
people line up to buy food. You watch a woman choose some items from the menu and hand some notes
and coins to the young man behind the counter. He is about the same age as you, and you think that he is
probably from China. After a few moments, he hands her some items, and she takes them to a table next
to yours.
Where are you? Based on this description, you could be almost anywhere in the world. This particular
fast-food restaurant is a Kentucky Fried Chicken, or KFC, but it could easily have been a McDonald’s, a
Burger King, or any number of other fast-food chains. Restaurants like this can be found in Auckland,
Buenos Aires, Cairo, Denver, Edinburgh, Frankfurt, Guangzhou, and nearly every other city in the world.
Here, however, the menu is written in French, and the customer paid in euros (€). Welcome to Paris.
While you are waiting, you look around you and realize that you are not looking at the world in the same
way that you previously did. The final exam you just completed was for an economics course, and—for
good or for ill—it has changed the way you understand the world. Economics, you now understand, is all
around you, all the time.

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1.1 Microeconomics in a Fast-Food Restaurant
LEARNING OBJECTIVE
1.

What kinds of problems do we study in microeconomics?

You watch another customer go to the counter and place an order. She purchases some fried chicken,
an order of fries, and a Coca-Cola. The cost is €10. She hands over a bill and gets the food in
exchange. It’s a simple transaction; you have witnessed exchanges like it thousands of times before.
Now, though, you think about the fact that this exchange has made both the customer and the store
better off than they were previously. The customer has voluntarily given up money to get food.
Presumably, she would do this only if having the food makes her happier than having the €10. KFC,
meanwhile, voluntarily gave up the food to get the €10. Presumably, the managers of the store would
sell the food only if they benefit from the deal as well. They are willing to give up something of value
(their food) in exchange for something else of value (the customer’s money).
Think for a moment about all the transactions that could have taken place but did not. For the same
€10, the customer could have bought two orders of fried chicken. But she didn’t. So even though you
have never met the person, you know something about her. You know that—at this moment at least—
she prefers having a Coca-Cola, fries, and one order of fried chicken to having two orders of fried
chicken. You also know that she prefers having that food to any number of other things she could
have bought with those euros, such as a movie theater ticket, some chocolate bars, or a book.
From your study of economics, you know that her decision reflects two different factors. The first is
her tastes. Each customer likes different items on the menu. Some love the spicy fried chicken;
others dislike it. There is no accounting for differences in tastes. The second is what she can afford.
She has a budget in mind that limits how much she is willing to spend on fast food on a given day.
Her decision about what to buy comes from the interaction between her tastes and her budget.
Economists have built a rich and complicated theory of decision making from this basic idea.
You look back at the counter and to the kitchen area behind it. The kitchen, you now know, is an
example of a production process that takes inputs and produces output. Some of the inputs are
perhaps obvious, such as basic ingredients like raw chicken and cooking oil. Before you took the

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economics course, you might have thought only about those ingredients. Now you know that there
are many more inputs to the production process, including the following:


The building housing the restaurant



The tables and chairs inside the room



The people working behind the cash register and in the kitchen



The people working at KFC headquarters managing the outlets in Paris



The stoves, ovens, and other equipment in the kitchen used to cook the food



The energy used to run the stoves, the ovens, the lighting, and the heat



The recipes used to convert the ingredients into a finished product

The outputs of KFC are all the items listed on the menu. And, you realize, the restaurant provides not
only the food but also an additional service, which is a place where you can eat the food.
Transforming these inputs (for example, tables, chickens, people, recipes) into outputs is not easy.
Let us examine one output—for example, an order of fried chicken. The production process starts
with the purchase of some uncooked chicken. A cook then adds some spices to the chicken and places
it in a vat of very hot oil in the huge pots in the kitchen. Once the chicken is cooked, it is placed in a
box for you and served to you at the counter. That production process uses, to a greater or lesser
degree, almost all the inputs of KFC. The person responsible for overseeing this transformation is the
manager. Of course, she doesn’t have to analyze how to do this herself; the head office provides a
detailed organizational plan to help her.
KFC management decides not only what to produce and how to produce it but also how much to
charge for each item. Before you took your economics course, you probably gave very little thought to
where those prices on the menu came from. You look at the price again: €5 for an order of fried
chicken. Just as you were able to learn some things about the customer from observing her decision,
you realize that you can also learn something about KFC. You know that KFC wouldn’t sell an order
of fried chicken at that price unless it was able to make a profit by doing so. For example, if a piece of
raw chicken cost €6, then KFC would obviously make a loss. So the price charged must be greater
than the cost of producing the fried chicken.

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KFC can’t set the price too low, or it would lose money. It also can’t set the price too high. What
would happen if KFC tried to charge, say, €100 for an order of chicken? Common sense tells you that
no one would buy it at that price. Now you understand that the challenge of pricing is to find a
balance: KFC needs to set the price high enough to earn a good profit on each order sold but not so
high that it drives away too many customers. In general, there is a trade-off: as the price increases,
each piece sold brings in more revenue, but fewer pieces are sold. Managers need to understand this
trade-off between price and quantity, which economists call demand. It depends on many things,
most of which are beyond the manager’s control. These include the income of potential customers,
the prices charged in alternative restaurants nearby, the number of people who think that going to
KFC is a cool thing to do, and so on.
The simple transaction between the customer and the restaurant was therefore the outcome of many
economic choices. You can see other examples of economics as you look around you—for example,
you might know that the workers earn relatively low wages; indeed, they may very well be earning
minimum wage. Across the street, however, you see a very different kind of establishment: a fancy
restaurant. The chef there is also preparing food for customers, but he undoubtedly earns a much
higher wage than KFC cooks.
Before studying economics, you would have found it hard to explain why two cooks should earn such
different amounts. Now you notice that most of the workers at KFC are young—possibly students
trying to earn a few euros a month to help support them through college. They do not have years of
experience, and they have not spent years studying the art of cooking. The chef across the street,
however, has chosen to invest years of his life training and acquiring specialized skills and, as a
result, earns a much higher wage.
The well-heeled customers leaving that restaurant are likewise much richer than those around you at
KFC. You could probably eat for a week at KFC for the price of one meal at that restaurant. Again,
you used to be puzzled about why there are such disparities of income and wealth in society—why
some people can afford to pay €200 for one meal while others can barely afford the prices at KFC.
Your study of economics has revealed that there are many causes: some people are rich because, like

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the skilled chef, they have abilities, education, and experience that allow them to command high
wages. Others are rich because of luck, such as those born of wealthy parents.
Everything we have discussed in this section—the production process, pricing decisions, purchase
decisions, and the employment and career choices of firms and workers—are examples of what we
study in the part of economics called microeconomics. Microeconomics is about the behavior of
individuals and firms. It is also about how these individuals and firms interact with each other
through markets, as they do when KFC hires a worker or when a customer buys a piece of fried
chicken. When you sit in a fast-food restaurant and look around you, you can see microeconomic
decisions everywhere.

KEY TAKEAWAY


In microeconomics, we study the decisions of individual entities, such as households and firms. We also
study how households and firms interact with each other.

CHECKING YOUR UNDERSTANDING
1.

List three microeconomic decisions you have made today.

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1.2 Macroeconomics in a Fast-Food Restaurant

LEARNING OBJECTIVE
1.

What kinds of problems do we study in macroeconomics?

The economic decisions you witness inside Kentucky Fried Chicken (KFC) are only a few examples of the
vast number of economic transactions that take place daily across the globe. People buy and sell goods
and services. Firms hire and lay off workers. Governments collect taxes and spend the revenues that they
receive. Banks accept deposits and make loans. When we think about the overall impact of all these
choices, we move into the realm of macroeconomics. Macroeconomics is the study of the economy as a
whole.
While sitting in KFC, you can also see macroeconomic forces at work. Inside the restaurant, some young
men are sitting around talking and looking at the newspaper. It is early afternoon on a weekday, yet these
individuals are not working. Like many other workers in France and around the world, they recently lost
their jobs. Across the street, there are other signs that the economy is not healthy: some storefronts are
boarded up because many businesses have recently been forced to close down.
You know from your economics class that the unemployed workers and closed-down businesses are the
visible signs of the global downturn, or recession, that began around the middle of 2008. In a recession,
several things typically happen. One is that the total production of goods and services in a country
decreases. In many countries, the total value of all the goods and services produced was lower in 2008
than it was in 2007. A second typical feature of a recession is that some people lose their jobs, and those
who don’t have jobs find it more difficult to find new employment. And a third feature of most recessions
is that those who do still have jobs are unlikely to see big increases in their wages or salaries. These
recessionary features are interconnected. Because people have lower income and perhaps because they
are nervous about the future, they tend to spend less. And because firms are finding it harder to sell their
products, they are less likely to invest in building new factories. And when fewer factories are being built,
there are fewer jobs available both for those who build factories and for those who work in them.
Down the street from KFC, a large construction project is visible. An old road and a nearby bridge are in
the process of being replaced. The French government finances projects such as these as a way to provide

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more jobs and help the economy recover from the recession. The government has to finance this spending
somehow. One way that governments obtain income is by taxing people. KFC customers who have jobs
pay taxes on their income. KFC pays taxes on its profits. And customers pay taxes when they buy their
food.
Unfortunately for the government, higher taxes mean that people and firms have less income to spend.
But to help the economy out of a recession, the government would prefer people to spend more. Indeed,
another response to a recession is to reduce taxes. In the face of the recession, the Obama administration
in the United States passed a stimulus bill that both increased government spending and reduced taxes.
Before you studied macroeconomics, this would have seemed quite mysterious. If the government is
taking in less tax income, how is it able to increase spending at the same time? The answer, you now
know, is that the government borrows the money. For example, to pay for the $787 billion stimulus bill,
the US government issued new debt. People and institutions (such as banks), both inside and outside the
United States, buy this debt—that is, they lend to the government.
There is another institution—called the monetary authority—that purchases government debt. It has
specific names in different countries: in the United States, it is called the Federal Reserve Bank; in
Europe, it is called the European Central Bank; in Australia, it is called the Reserve Bank of Australia; and
so on. When the US government issues more debt, the Federal Reserve Bank purchases some of it. The
Federal Reserve Bank has the legal authority to create new money (in effect, to print new currency) and
then to use that to buy government debt. When it does so, the currency starts circulating in the economy.
Similarly, decisions by the European Central Bank lead to the circulation of the euro notes and coins you
saw being used to purchase fried chicken.
The decisions of the monetary authority have a big impact on the economy as well. When the European
Central Bank decides to put more euros into circulation, this has the effect of reducing interest rates,
which means it becomes cheaper for individuals to get a student loan or a mortgage, and it is cheaper for
firms to buy new machinery and build new factories. Typically, another consequence is that the euro will

become less valuable relative to other currencies, such as the US dollar. If you are planning a trip to the
United States now that your class is finished, you had better hope that the European Central Bank doesn’t
increase the number of euros in circulation. If it does, it will be more expensive for you to buy US dollars.
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Today, the world’s economies are highly interconnected. People travel from country to country. Goods are
shipped around the world. If you were to look at the labels on the clothing worn by the customers in KFC,
you would probably find that some of the clothes were manufactured in China, perhaps some in Malaysia,
some in France, some in the United States, some in Guatemala, and so on. Information also moves around
the world. The customer sitting in the corner using a laptop might be in the process of transferring money
from a Canadian bank account to a Hong Kong account; the person at a neighboring table using a mobile
phone might be downloading an app from a web server in Illinois. This globalization brings many
benefits, but it means that recessions can be global as well.
Your study of economics has taught you one more thing: the idea that you can take a trip to the United
States would have seemed remarkable half a century ago. Despite the recent recession, the world is a
much richer place than it was 25, or 50, or 100 years ago. Almost everyone in KFC has a mobile phone,
and some people are using laptops. Had you visited a similar fast-food restaurant 25 years ago, you would
not have seen people carrying computers and phones. A century ago, there was, of course, no such thing
as KFC; automobiles were still a novelty; and if you cut your finger on the sharp metal edge of a table, you
ran a real risk of dying from blood poisoning. Understanding why world economies have grown so
spectacularly—and why not all countries have shared equally in this growth—is one of the big challenges
of macroeconomics.

KEY TAKEAWAY


In macroeconomics, we study the economy as a whole to understand why economies grow and why they

sometimes experience recessions. We also study the effects of different kinds of government policy on
the overall economy.

CHECKING YOUR UNDERSTANDING
1.

If the government and the monetary authority think that the economy is growing too fast, what could
they do to slow down the economy?

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1.3 What Is Economics, Really?
LEARNING OBJECTIVE
1.

What methods do economists use to study the world?

Economists take their inspiration from exactly the kinds of observations that we have discussed.
Economists look at the world around them—from the transactions in fast-food restaurants to the policies
of central banks—and try to understand how the economic world works. This means that economics is
driven in large part by data. In microeconomics, we look at data on the choices made by firms and
households. In macroeconomics, we have access to a lot of data gathered by governments and
international agencies. Economists seek to describe and understand these data.
But economics is more than just description. Economists also build models to explain these data and
make predictions about the future. The idea of a model is to capture the most important aspects of the
behavior of firms (like KFC) and individuals (like you). Models are abstractions; they are not rich enough
to capture all dimensions of what people do. Yet a good model, for all its simplicity, is still capable of

explaining economic data.
And what do we do with this understanding? Much of economics is about policy evaluation. Suppose your
national government has a proposal to undertake a certain policy—for example, to cut taxes, build a road,
or increase the minimum wage. Economics gives us the tools to assess the likely effects of such actions
and thus to help policymakers design good public policies.
This is not really what you thought economics was going to be about when you walked into your first class.
Back then, you didn’t know much about what economics was. You had a vague thought that maybe your
economics class would teach you how to make money. Now you know that this is not really the point of
economics. You don’t have any more ideas about how to get rich than you did when you started the class.
But your class has taught you something about how to make better decisions and has given you a better
understanding of the world that you live in. You have started to think like an economist.

KEY TAKEAWAY


Economists gather data about the world and then build models to explain those data and make
predictions.

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CHECKING YOUR UNDERSTANDING
1.

Suppose you were building a model of pricing at KFC. Which of the following factors would you want
to make sure to include in your model? Which factors do you think would be irrelevant?
a.

the age of the manager making the pricing decisions

b.

the price of chicken

c.

the number of customers who come to the store on a typical day

d.

the price of apples

e.

the kinds of restaurants nearby

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1.4 End-of-Chapter Material
In Conclusion
Economics is all around us. We all make dozens of economic decisions every day—some big, some small.
Your decisions—and those of others—shape the world we live in. In this book, we will help you develop an
understanding of economics by looking at examples of economics in the everyday world. Our belief is that
the best way to study economics is to understand how economists think about such examples.
With this in mind, we have organized our book rather differently from most economics textbooks. It is

built not around the theoretical concepts of economics but around different applications—economic
illustrations as you encounter them in your own life or see them in the world around you. As you read this
book, we will show you how economists analyze these illustrations, introducing you to the tools of
economics as we proceed. After you have read the whole book, you will have been introduced to all the
fundamental tools of economics, and you will also have seen them in action. Most of the tools are used in
several different applications, thus allowing you to practice using them and gain a deeper understanding
of how they work.
You can see this organization at work in our table of contents. In fact, there are two versions of the table of
contents so that both students and instructors can easily see how the book is organized. The student table
of contents focuses on the applications and the questions that we address in each chapter. The instructor
table of contents lists the theoretical concepts introduced in each chapter so that instructors can easily see
how economic theory is developed and used in the book.
We have also gathered all the tools of economics into a toolkit. You will see many links to this toolkit as
you read the book. You can refer to the toolkit as needed when you want to be reminded of how a tool
works, and you can also use it as a study aid when preparing for exams and quizzes.

EXERCISES
1.

A map is a model constructed by geographers and cartographers. Like an economic model, it is a
simplified representation of reality. Suppose you have a map of your hometown in front of you. Think of

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one question about your town that you could answer using the map. Think of another question about
your town for which the map would be useless.
2.

Which of the following questions do you think would be studied by a macroeconomist and which by a
microeconomist? (Note: we don’t expect you to be able to answer all these questions yet.)
a.

What should the European Central Bank do about increasing prices in Europe?

b.

What happens to the price of ice cream in the summer?

c.

Should you take out a student loan to pay for college?

d.

What happens when the US government cuts taxes and pays for these tax cuts by borrowing
money?

e.

What would happen to the prices of computers if Apple and Microsoft merged into a single
firm?

Economics Detective
1.

Look at a newspaper on the Internet. Find a news story about macroeconomics. How do you know that it
is about macroeconomics? Find a news story about microeconomics. How do you know that it is about

microeconomics?

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Chapter 2
Microeconomics in Action
2.1 Four Examples of Microeconomics
LEARNING OBJECTIVES
1.

What are two ways that you make economic choices all the time?

2.

How do economists think about the way people react to a change in a rule?

3.

What is the role of markets in an economy?

Here are four short and diverse illustrations of microeconomics you might encounter: deciding what to do
with your time and money, buying or selling on eBay, visiting a large city, and reading about a soccer
game. After you have finished your study of microeconomics, you will see these concepts very differently
from the way you see them now. You may not know it, but your everyday life is filled with microeconomics
in action.

Your Time and Money

Wouldn’t you rather be doing something else with your time right now, instead of reading an economics
textbook? You could be surfing on the Internet, reading blogs, or updating your Facebook profile. You
could be reading a novel or watching television. You could be out with friends. But you aren’t. You have
made a choice—a decision—to spend time reading this chapter.
Your choice is an economic one. Economics studies how we cope with competing demands for our time,
money, and other resources. You have only 24 hours each day, so your time is limited. Each day you have
to divide up this time among the things you like or need to do: sleeping, eating, working, studying,
reading, playing video games, hanging out in your local coffee shop, and so on. Every time you decide to
do one thing instead of another, you have made an economic decision. As you study economics, you will
learn about how you and other people make such choices, and you will also learn how to do a better job
when making these decisions.
Money is also a limited resource. You undoubtedly have many things you would like to buy if money were
no object. Instead you must choose among all the different things you like because your money—or, more
precisely, your income—is a limited resource. Every time you buy something, be it a T-shirt, a breakfast
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bagel, or a new computer, you are choosing to forgo something else you could have bought instead. Again,
these are economic decisions. Economics is about how you make choices. Whenever there is a limited
resource—be it your time, the amount of oil reserves in the world, or tickets to the Super Bowl—and
decisions to be made about how to use that resource, then economics is there to help. Indeed, the
fundamental definition of economics is that it is the study of how we, as individuals and as a society,
allocate our limited resources among possible alternative uses.

eBay and craigslist
Suppose you want to buy an MP3 player. There are many ways you can do this. You can go to a local store.
You can look for stores on the Internet. You can also visit sites such as eBay () or
craigslist (). eBay is an online auction site, meaning that you can look for an

MP3 player and then bid against other potential buyers. The site craigslist is like an online version of the
classified advertisements in a newspaper, so you can look to see if someone in your town or city is selling
the player you want to buy. You can also use these sites if you want to sell something. Maybe you have
some old baseball cards you want to sell. Perhaps you have a particular skill (for example, web design),
and you want to sell your services. Then you can use sites such as eBay or craigslist as a seller instead of as
a buyer.
We have said that economics is about deciding how to use your limited resources. It is also about how we
interact with one another, and, more precisely, how we trade with one another. Adam Smith, the founder
of modern economics, observed that humans are the only animal that makes bargains: “Nobody ever saw
a dog make a fair and deliberate exchange of one bone for another with another dog.”

[1]

Barter or trade—

the exchange of goods and services and money—is central to the world we live in today.
Economists often talk about trade taking place in markets. Some exchanges do literally take place in
markets—such as a farmers’ market where local growers bring produce to sell. Economists use the term
more generally, though: a market is any institution that allows us to exchange one thing for another. Sites
such as eBay and craigslist create markets in which we can transact. Normally, we exchange goods or
services for money. Sometimes we exchange one good or service for another. Sometimes we exchange one
type of money for another.

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Most of the time, nobody forces you to buy anything, so when you give up some money in return for an
MP3 player, you are presumably happier after the transaction than before. (There are some exceptions, of

course. Can you think of any cases where you are forced to engage in an economic transaction?) Most of
the time, nobody forces you to sell anything, so when you give up your time in return for some money, you
are presumably happier after the transaction than before. Leaving aside the occasional mistake or the
occasional regret, nearly every voluntary transaction makes both participants better off. Markets matter
because they are a means for people to become happier.

Breathing the Air
Welcome to Mexico City! It is a wonderful place in many respects. But not in every way: from the picture
you can see that Mexico City has some of the most polluted skies in the world.

[2]

Mexico City was not always so polluted. Sadly, economic growth and population growth, together with the
peculiarities of geography and climate, have combined to make its air quality among the worst you will
encounter anywhere. Other cities around the world, from Beijing to Los Angeles, also experience
significant air pollution, reducing the quality of life and bringing with it health risks and other costs.
It is hard to understand economists talking about the beauty and power of markets when you cannot
breathe the air. So what is going wrong in Mexico City? Is it not full of people carrying out trades that
make them better off? The problem is that transactions sometimes affect other people besides the buyer
and the seller. Mexico City is full of gas stations. The owners of the gas stations are happy to sell gasoline
because every transaction makes them better off. The owners of cars are happy to buy gasoline because
every transaction makes them better off. But a side effect of all these transactions is that the air becomes
more and more polluted.
Economics studies these kinds of problems as well. Economists seek to understand where and when
markets work and where and when they don’t work. In those situations where markets let us down,
economists search for ways in which economic policies can help.

Changing the Rules

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We have explained that microeconomics studies choices and the benefits and problems that arise from
trade. Perhaps most fundamentally, microeconomics studies how people respond to incentives. To
illustrate the importance of incentives, here is an example of what can happen when they go wrong.
In February 1994, an extraordinary scene took place during a soccer match in the Caribbean. Grenada was
playing Barbados, and with five minutes remaining in the match, Barbados was leading by two goals to
one. As the seconds ticked away, it seemed clear that Barbados was going to win the match. Then, three
minutes from the end of the game, the Barbados team did a remarkable thing. It intentionally scored an
own goal, tying the game at two goals apiece.
After Grenada kicked off again, pandemonium ensued. The Grenada team tried not only to score against
Barbados but also to score an own goal. Barbados desperately defended both its own goal and its
opponents’ goal. The spectacle on the field had very little to do with soccer as it is usually played.
To explain this remarkable sight, we must describe the tournament in which the two teams were playing.
There were two groups of teams, with the winner of each group progressing to the final. The match
between Barbados and Grenada was the last group game and would determine which two teams would be
in the final. The results of the previous matches were such that Barbados needed to win by two goals to go
to the final. If Barbados won by only one goal, then Grenada would qualify instead. But the tournament
organizers had introduced an unusual rule. The organizers decided that if a game were tied, the game
would go to “golden goal” overtime, meaning that the first team to score would win the game, and they
had also decided that the winning team would then be awarded a two-goal victory.
As the game was drawing to a close, Barbados realized it was unlikely to get the two-goal win that it
needed. The team reasoned that a tie was a better result than a one-goal victory because it gave them
roughly a fifty-fifty chance of winning in extra time. So Barbados scored the deliberate own goal. Grenada,
once it realized what had happened, would have been happy either winning or losing by one, so it tried to
score in either goal. Barbados’ strategy paid off. The game finished in a tie; Barbados scored in overtime
and went on win the final.
The organizers should have consulted an economist before instituting the rules of the tournament.

Economics has many lessons to teach, and among the most important is this: people respond to
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incentives. The change in the rules changed the incentives that the two teams faced. Because the
tournament organizers had not realized that their rules could lead to a situation in which a team preferred
a tie to a win, they failed to foresee the bizarre scene on the field.

[3]

KEY TAKEAWAYS


You make economic decisions on the allocation of time by deciding how to spend each minute of the day.
You make economic decisions on the allocation of your income by deciding how much to buy of various
goods and services and how much to save.



Economists study how changes in rules lead individual and firms to change their behavior. This is part of
the theme in economics that incentives matter.



Markets are one of the central ways in which individuals interact with each other. Market interactions
provide a basis for the trade that occurs in an economy.

CHECKING YOUR UNDERSTANDING

1.

When you are choosing how much time to allocate to studying, what incentives affect your decision?
Does the decision depend on how much money you have? Does the decision depend on whether you
have a quiz or an exam coming up in the course? If your instructor changed the rules of the course—for
example, by canceling the final exam—would your choice change?

2.

Instead of writing about air pollution in Mexico City, we could have written about water pollution from
the 2010 oil spill in the Gulf of Mexico. Would that also be a good example of markets failing?

[1] Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (New York: Modern Library, 1994
[1776]), 14.
[2] “Researchers to Scrutinize Megacity Pollution during Mexico City Field Campaign,”University Corporation for
Atmospheric Research, last modified March 2, 2006, accessed January 22,
2011, />[3] “Football Follies,” Snopes.com, last modified July 6, 2008, accessed January 22,
2011, />
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2.2 The Microeconomic Approach
LEARNING OBJECTIVES
1.

What is the approach of microeconomics?

2.

What are the big questions of economics?

There are several distinguishing features of the microeconomic approach to the world. We discuss them
briefly and then conclude with a look at the big questions of economics.

Individual Choice
One element of the microeconomic approach is individual choice. Throughout this book, we explore how
individuals make decisions. Economists typically suppose that individuals make choices to pursue their
(broadly defined) self-interest given the incentives that they face.
We look at individuals in their roles both as members of households and as members of firms. Individuals
in households buy goods and services from other households and—for the most part—firms. They also sell
their labor time, mostly to firms. Managers of firms, meanwhile, make decisions in the effort to make
their firms profitable. By the end of the book, we will have several frameworks for understanding the
behavior of both households and firms.
Individuals look at the prices of different goods and services in the economy when deciding what to buy.
They act in their own self-interest when they purchase goods and services: it would be foolish for them to
buy things that they don’t want. As prices change, individuals respond by changing their decisions about
which products to buy. If your local sandwich store has a special on a breakfast bagel today, you are more
likely to buy that sandwich. If you are contemplating buying an Android tablet computer but think it is
about to be reduced in price, you will wait until the price comes down.
Just as consumers look at the prices they face, so do the managers of firms. Managers look at the wages
they must pay, the costs of the raw materials they must purchase, and so on. They also look at the
willingness of consumers to buy the products that they are selling. Based on all this information, they
decide how much to produce and what to buy. Your breakfast bagel may be on special because the owner

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of your local sandwich shop got a good deal on bagels from the supplier. So the owner thinks that
breakfast bagels can be particularly profitable, and to sell a lot of them, she sets a lower price than normal.
The buying and selling of a bagel may seem trivial, but similar factors apply to much bigger decisions.
Potential students think about the costs and benefits of attending college relative to getting a full-time job.
For some people, the best thing to do is to work full time. For others, it is better to go to school full time.
Yet others choose to go to school part time and work part time as well. Presumably your own decision—
whichever of these it may be—is one you made in your own best interests given your own specific
situation.
From this discussion, you may think that economics is all about money, but economists recognize that
much more than money matters. We care about how we spend our time. We care about the quality of the
air we breathe. We care about our friends and family. We care about what others think of us. We care
about our own self-image: what sort of a person am I? Such factors are harder to measure and quantify,
but they all play a role in the decisions we make.

Markets
A second element of microeconomics has to do with how individual choices are interconnected.
Economics is partly about how we make decisions as individuals and partly about how we interact with
one another. Most importantly—but not exclusively—economics looks at how people interact by
purchasing and selling goods and services.
In a typical transaction, one person (the buyer) hands over money to another (the seller). In return, the
seller delivers something (a good or a service) to the buyer. For example, if you buy a chocolate bar for a
dollar, then a dollar bill goes from your hands to those of the seller, and a chocolate bar goes from the
seller to you. At the level of an individual transaction, this sounds simple enough. But the devil is in the
details. In any given (potential) transaction, we can ask the following questions:


How many? Will you buy 1, 2, or 10 chocolate bars? Or will you buy 0—that is, will the transaction
take place at all?



How much? How much money does the buyer give to the seller? In other words, what is the price?

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You will see in different chapters of this book that the answers to these questions depend on exactly how
buyers and sellers interact. We get a different answer depending on whether there are many sellers or only
a few. We get a different answer if the good is sold at a retail store or at an auction. We get a different
answer if buyers and sellers can or cannot negotiate. The exact way in which people exchange goods and
services matters a great deal for the how many? andhow much? questions and thus for the gains from
trade in the economy.

The Role of Government
We have pointed out that individuals acting in their own self-interest benefit from voluntary trade. If you
are not forced to buy or sell, then there is a presumption that every transaction makes the participants
happier. What is more, markets are often a very effective institution for allowing people to meet and trade
with one another. In fact, there is a remarkable result in economics that—under some circumstances—
individuals acting in their own self-interest and trading in markets can manage to obtain all the possible
benefits that can come from trading. Every transaction carried out is for the good, and every good
transaction is carried out. From this comes a powerful recommendation: do whatever is possible to
encourage trade. The phrase under some circumstances is not a minor footnote. In the real world,
transactions often affect people other than the buyer and the seller, as we saw in our example of gas
stations in Mexico City. In other cases, there can be problems with the way that markets operate. If there
is only a small number of firms in a market, then managers may be able to set high prices, even if it means
that people miss out on some of the benefits of trade. Later in this book, we study exactly how managers
make these decisions. The microeconomic arguments for government intervention in the economy stem

from these kinds of problems with markets. In many chapters, we discuss how governments intervene in
an attempt to improve the outcome that markets give us. Yet it is often unclear whether and how
governments should be involved. Pollution in Mexico City illustrates how complex these problems can be.
First, who is responsible for the pollution? Some of it comes from people and firms outside the city and
perhaps even outside the country. If pollution in Mexico City is in part caused by factories in Texas, who
should deal with the problem: the Mexico City government, the Mexican government, the US government,
or the Texas state legislature? Second, how much pollution should we tolerate? We could shut down all
factories and ban all cars, but few people would think this is a sensible policy. Third, what measures can

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we use to combat air pollution? Should we simply place limits on production by firms and the amount of
driving? Should we use some kind of tax? Is there a way in which we can take advantage of our belief that
people, including the managers of firms, respond to incentives?
There are two traps that we must avoid. The first is to believe that markets are the solution to everything.
There is no imaginable market in which the residents of Mexico City can trade with the buyers and sellers
of gasoline to purchase the right amount of clean air. The second trap is to believe that the government
can fix every market failure. Governments are collections of individuals who respond to their own
incentives. They can sometimes make things better, but they can sometimes make things worse as well.
There is room for lots of disagreement in the middle. Some economists think that problems with markets
are pervasive and that government can do a great deal to fix these problems. Others think that such
problems are rare and that governmental intervention often does more harm than good. These
disagreements result partly from different interpretations of the evidence and partly from differences in
politics. Economists are as prone as everyone else to view the world through their own ideological lens. As
we proceed, we do our best to present the arguments on controversial issues and help you understand why
even economists sometimes come to differing conclusions about economic policy.

Incentives
Perhaps our story of the Barbados-Grenada soccer game did not seem related to economics. Economists
believe, though, that the decisions we make reflect the incentives we face. Behavior that seems strange—
such as deliberately scoring an own goal in a soccer game—can make perfect sense once you understand
the underlying incentives. In the economic world, it is often governments that make the rules of the game;
like the organizers of soccer tournaments, governments need to be careful about how the rules they set
can change people’s behavior.
Here is an example. In some European countries, laws are in place that give a lot of protection to workers
and keep them from being unfairly fired by their employers. The intentions of these laws are good; some
of their consequences are not so beneficial. The laws also make firms more reluctant to hire workers
because they are worried about being stuck with an unsuitable employee. Thus these laws probably
contribute to higher unemployment.
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